Index funds are the closest thing investing has to a consensus recommendation. Warren Buffett has publicly said most investors would be better off in a low-cost index fund than trying to pick stocks or paying someone else to pick them. Here’s what they are, how they work, and why they’ve become the default choice for long-term investors.
What an index fund is
An index fund is a type of investment fund — either a mutual fund or an ETF — that tracks a specific market index rather than trying to beat it. A market index is just a list of stocks or bonds grouped by a set of rules. The S&P 500 index, for example, tracks the 500 largest publicly traded companies in the United States. An S&P 500 index fund simply buys all 500 of those companies in proportion to their size, aiming to match the index’s performance rather than outperform it. That’s it.
Active vs passive investing
Index funds are “passive” investments — they follow the index mechanically without a fund manager making judgment calls about what to buy or sell. The alternative is “active” investing, where a portfolio manager researches stocks and tries to select the ones that will outperform the market. Active management sounds appealing, but decades of data show that most actively managed funds underperform their benchmark index over long periods — especially after accounting for their higher fees. A 2023 S&P SPIVA report found that over 15 years, more than 90% of large-cap active funds underperformed the S&P 500. Index funds don’t try to beat the market; they just try to match it — and that turns out to be extremely difficult to beat consistently.
The most common indexes and what they track
- S&P 500. The 500 largest US companies by market cap. Covers roughly 80% of the total US stock market value. The most widely held index in the world.
- Total Stock Market Index. Tracks the entire US stock market — large, mid, and small cap. More diversification than the S&P 500 alone.
- Total International Stock Market Index. Stocks from developed and emerging markets outside the US. Used alongside a US index for global diversification.
- Bloomberg US Aggregate Bond Index. The benchmark for US investment-grade bonds. Bond index funds tracking this index are a common conservative component of balanced portfolios.
- Nasdaq-100. The 100 largest non-financial companies listed on the Nasdaq, heavily weighted toward technology. More volatile than the S&P 500 but stronger growth historically.
Why fees matter so much
Index funds have very low expense ratios because they require minimal management. Vanguard’s S&P 500 index fund (VFIAX) charges 0.04% per year — that’s $4 annually on a $10,000 investment. A comparable actively managed fund might charge 0.75–1.25%, or $75–$125 per year on the same investment. That difference compounds dramatically over time. On a $100,000 portfolio growing at 7% annually over 30 years, a 1% annual fee difference results in roughly $200,000 less wealth at retirement. The fee isn’t small — it’s one of the most important variables in long-term investing outcomes.
How to buy an index fund
You can buy index funds through any brokerage account — Fidelity, Vanguard, Schwab, or your 401(k) or IRA. Most brokerages offer their own index funds with no transaction fees. When choosing between similar index funds tracking the same index, compare three things: the expense ratio (lower is better), the minimum investment (many have none), and the tracking error (how closely the fund actually matches its index). For most investors, the Vanguard, Fidelity, and Schwab versions of major index funds are functionally identical — the differences are negligible.
Index funds vs ETFs
Index funds come in two structures: traditional mutual funds and ETFs. Both can track the same index, but ETFs trade on exchanges throughout the day like stocks, while mutual funds price once daily after market close. ETFs often have slightly lower expense ratios and no minimum investment, making them accessible for investors starting with small amounts. For most long-term investors, the distinction is minor — what matters is the index being tracked and the expense ratio, not the fund structure.
The case for making index funds your core holding
The standard recommendation from most fee-only financial advisors and academic research is to build a portfolio’s core around low-cost, diversified index funds — a US total market fund, an international fund, and a bond fund — and adjust the allocation based on your time horizon and risk tolerance. This approach, sometimes called the “three-fund portfolio,” gives you ownership of thousands of companies across the global economy, costs almost nothing in fees, requires minimal maintenance, and has historically outperformed the majority of professional fund managers over long time periods. It’s not exciting, but it works.